In December 2017 the Risk Transformation Regulations were passed, enabling the incorporation of Insurance Linked Securities (ILS) vehicles in the UK for the first time. So far there have been 2 issuances (a collateralised reinsurance vehicle for Neon syndicate and a cat bond for SCOR), with rumours of many more in the pipeline.
Opinions of the new regulations have been mixed, from those excited by the potential development of London as an ILS hub, to those who believe it is simply 'too little too late'; after all, if you can go to Bermuda for your cheap alternative capacity on your property Cat XL already, what's new in London?
Although no one is saying that London is going to replace Bermuda as an ILS centre, there is an opportunity for it to grow to complement Bermuda, possibly in new and exciting ways- by making ILS accessible to more capacity, and providing the ecosystem for innovation in the ILS space.
Firstly, despite the phenomenal growth of alternative reinsurance capital over the last 20 years (it is now estimated to be as much as $100bn worldwide), it remains just a drop in the ocean for total institutional wealth. Given the obvious benefits of ILS as an investment class – most significantly its low correlation with other assets – it is perhaps surprising that the above number is not significantly higher. Insurance linked securities have yet to materially make their mark as an alternative asset class, especially in Europe; Mercer recently published the findings of its latest Asset Allocation survey, which found that just 1% of European pension funds invest in ILS at all. Facilitating ILS in London, with its highly regarded regulatory regime and London's critical mass as a centre for investing, may be the catalyst to increasing the appetite of these institutions for insurance risk.
Secondly – and perhaps more excitingly – the breadth of expertise in the London financial ecosystem means that it may provide the opportunity to move ILS beyond its comfort zone, backing new lines of business and perhaps even altering how insurance risk is structured for investors.
Commentators regularly state that it is inevitable that alternative capital will be put to other lines of business outside of its traditional 'home' of property catastrophe, but investors remain uncertain about other insurance risks that may lock in cash for lengthier periods, may not be as diversifying in a portfolio and are more opaque in their risk exposure and loss verification. To date, 'non property cat' lines of business therefore remain something of a niche sideline in the ILS world.
For new ILS exposures to truly take off, there needs to be a confluence of expertise from insurers and investors, as well as sufficient scale in the premium volumes to overcome frictional costs – and this is where London can offer something different. Cyber, terrorism, political risk, space, marine hull, cargo – these are all lines of business that fit with investors' current preferred profile of insurance risk, and are written on an unsurpassed scale in the London market. It is possible that the new regulations are just what is needed to bring alternative capacity towards these other risks.
Beyond extending ILS in to other lines of business, London could be pivotal in reshaping how ILS is perceived, leading to risks being packaged together in to tailored investments to fit a preferred duration/risk-return profile, and potentially even traded on a secondary market.
As investors get more sophisticated in what qualities they expect from their alternative asset allocation, ILS may no longer simply be seen as a good investment on a relative value basis, and instead qualities like cash flow, duration and risk profile will become more important to support the investor's overall ALM strategy. The sheer diversity of risks that are written in the London market - combined with London's ecosystem of investors, brokers, investment banks, lawyers, accountants (and of course, underwriters) - mean that if it is possible to pool together insurance risks in to a tailored product, fitting specific qualities an investor demands, it is in London.
The logical extreme of ILS would see it mimic other securitised cashflows and form tradable packages split into tranches, which investors can sell on in a truly liquid secondary market. This vision remains somewhat distant, with a key challenge being the due diligence required to properly understand the valuation of the liabilities creating too significant a frictional cost for secondary trading for all but the most standardised products. However new technologies like blockchain (which could enable 'real time' loss reporting and more transparent claims valuation), combined with the application of big data and artificial intelligence to reserving, may make valuing liabilities for the purposes of secondary market trading much more efficient.
Of course for this to happen there would need to be engagement from wide ranging stakeholder expertise, and it is again here that London's financial ecosystem gives it a natural advantage as the incubator of this innovation. Investors, insurers, regulators, and technology experts can all be brought together to create methods for valuing liabilities using new technology that can obtain market wide acceptance. Of course, other stakeholders (such as Big 4 firms!) can do their bit by thinking about ways to improve efficiency in insurance liability valuation in the meantime.
Bringing alternative capacity more directly to support insurance risk will ultimately help consumers and better protect society against unexpected events. With the UK Risk Transformation Regulations, London can lead the way in this evolution.
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